Stock valuations now versus last April

Commentary: Market isn’t quite as overvalued now as then

CHAPEL HILL, N.C. (MarketWatch) — Does the stock market’s behavior over the last 10 months add up to a lot of sound and fury signifying nothing?

It certainly looks that way on the surface. The S&P 500 index
SPX, +0.01%
, for example, is just 0.3% higher now than where it closed at the end of last April. For all intents and purposes, that’s a wash — especially considering the extraordinary volatility the market has had to endure along the way.

There have been some at least moderately encouraging sub-surface developments, however, especially on the valuation front. Relative to earnings, the market is in slightly better shape now than 10 months ago.

Consider first the price-to-earnings ratio when calculated on the basis of trailing as-reported earnings. The reason to calculate the ratio this way: It’s comparable to the historical values back to 1871 that are included in the database maintained by Yale University finance professor Robert Shiller. (Click here to access that database.)

That ratio for the S&P currently stands at 15.2. The comparable ratio at the end of last April stood at 16.6. So at least according to this measure, stocks are about 8% cheaper today than last April.

What about the so-called Cyclically Adjusted Price Earnings ratio, or CAPE, which Shiller has proposed as a superior measure of stock market valuation? It currently stands at 22.7, versus 23.7 at the end of this past April — a 4% improvement.

Though the magnitude of these improvements are perhaps not overwhelming, at least their trends are in the right direction.

There are several flies in the ointment, however. And at least one of them is a serious cause for concern.

One that many of the advisers I monitor have been noting: Earnings-growth rates are markedly lower now than they were last year. As recently as the quarter that ended last Sept. 30, for example, the year-over-year EPS growth rate for the S&P was 21%. For the quarter we’re in right now, in contrast, that growth rate is estimated to be just 12.5% — and even that may turn out to be optimistic.

This turns out not to be as big a worry as it might otherwise seem, however.

Earnings growth rates that are too high are simply not sustainable for very long, as illustrated in the accompanying chart. That chart, based on data from Ned Davis Research, shows that the market over the last nine decades has actually tended to do better when earnings are growing more slowly than when growing at the blistering pace seen over the last couple of years.

A potentially more serious fly in the ointment: Though Shiller’s Cyclically Adjusted Price Earnings Ratio is slightly lower than it was at the market high last April, it remains significantly above its long-term norms. In fact, it is 38% higher than the ratio’s average back to the late 1800s, and 43% higher than its median.

This cannot easily be dismissed because Shiller’s CAPE has an impressive record forecasting the market’s long-term return. Consider a simple econometric model that uses the CAPE to predict the S&P 500’s inflation-adjusted dividend-adjusted return — a model that is quite significant at the 95% confidence level that statisticians often use to determine if a pattern is genuine.

That model’s current forecast: Less than a 1% annualized real total return over the next decade. That’s far lower than the long-term average of close to 7% per year.

To be sure, this is a very long-term forecast. The CAPE can remain at well-above-average levels for several years, and even creep higher. Long-term valuations exert only a weak gravitational pull on the market’s shorter-term returns.

The bottom line? From a long-term point of view, stocks are overvalued relative to historical norms. But, from a shorter-term perspective, the good news is that they are not quite as overvalued as they were last April.

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